By Blaine Thiederman MBA, CFP Date: 08/18/2022
Disclosure: Before reading this, don’t see this as anything more than financial education. This is not a recommendation of any strategy and before you take action on your ISOs, consult a tax professional or a financial planner that is your financial planner. We are not your financial planner but if you’d like us to be, click here to schedule an appointment.
KEY TAKEAWAYS
- Incentive stock options (ISOs) are popular measures of employee compensation, granting rights to company stock at a discounted price at a future date.
- This type of employee stock purchase plan is intended to retain key employees or managers.
- ISOs require a vesting period of at least two years and a holding period of more than one year before they can be sold.
- ISOs often have more favorable tax treatment on profits than other types of employee stock purchase plans.
What Are Incentive Stock Options (ISOs)?
Incentive stock options are a type of employee stock option that offers certain tax advantages. ISOs are only available to employees and cannot be transferred or sold. If the ISO holder exercises the option, they must hold onto the stock for at least one year from the time of exercise before selling it in order to qualify for lower tax rates (long-term capital gains) on the dollar amount they gain. If the shares are sold before the one-year mark following the date of exercise, any gains are treated as short-term capital gains and taxed at the higher ordinary income tax rate. However, if the shares are held for more than one calendar year, the gains are considered long-term capital gains and taxed at a lower rate. There are a few other key things to know about ISOs: The exercise price must be at least equal to the fair market value of the shares on the option grant date. ISOs can be exercised anytime during the option period, which is typically 10 years. The option must be granted by a corporation in which you are employed (or were employed within the past 12 months). Now that you know a little more about ISOs, you can start thinking about whether they might be right for you.
To put it in simpler terms for the less-than-financially-astute among us, think about ISOs as coupons that your employer gives you that you can choose to use or throw away. If you choose to use the coupon, you may have to pay tax on the discount you receive on the item you bought using it.
So, if you saw the coupon gave you the ability to buy steak at $20/lb and you found the same steak selling for $15 a pound at the grocery store, would you use the coupon? Of course not. You’d just buy it at the store for whatever it’s selling for that’s less than $20/lb.
Understanding Incentive Stock Options (ISOs)
Incentive stock options are offered by some companies to encourage employees to remain long-term with a company and contribute to its growth and development and to the subsequent rise in its stock price. The way this works is, ISOs regularly have vesting periods and don’t permit you to exercise them whenever you please.
ISOs are usually issued by publicly-traded companies (meaning trade on a major stock exchange like the New York Stock Exchange or the NASDAQ), or private companies planning to go public at a future date, and require a plan document that clearly outlines how many options are to be given to which employees. Those employees must exercise their options within 10 years of receiving them.
Incentive Stock Options typically serve as a form of compensation that augments salaries, or as a reward in place of a raise. Stock options, like other benefits, can be used as a way to attract and retain talent, especially if the company cannot currently afford to pay competitive base salaries or if the company is in an industry where competition for talent is high (like tech).
How Incentive Stock Options (ISOs) Work
Stock options are issued, or “granted,” at a price set by the employer company, called the “strike price” (aka a fixed price to buy the stock at) This is typically around 10% less than what the shares are selling for at that moment in time.
ISOs are issued by your employer on a specific date, known as the grant date, and then the employee gets to choose when they buy the stock using their Incentive Stock Options at some date in the future. Once the options are exercised, the employee can sell the stock immediately or wait as long as they want before selling it. Unlike traditional stock options, the amount of time you get to wait before using an ISO to buy the stock is almost always 10 years.
The main benefit of ISOs to the employee is the ability to buy the stock at a predetermined price which may be substantially less than what the stock is actually worth on the market. For example, if you worked at Exxon Mobile and you got some ISOs from your employer giving you the ability to buy the stock for $10 a share and the stock was worth $200 a share, you could exercise your ISOs, buy the stock for $10 and immediately sell it for $200, profiting $190 a share. Not bad!
Typically the Employee Stock Options or ESOs (a different type of ISOs) have a vesting schedule that has to be satisfied before you can exercise them. Traditionally the vesting schedule is a 3-year cliff (meaning you have to work there for 3 years before you can use the ESOs to buy the stock).
What are Non-Qualified Stock Options?
Non-qualified stock options (NQSOs) are a type of employee stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code. Employees typically receive NQSOs as part of their compensation package from their employer. NQSOs are also sometimes referred to as “nonstatutory stock options.” NQSOs are subject to income tax at the time they are exercised, and they may also be subject to payroll taxes. When the underlying shares are sold, any resulting capital gain or loss will be treated as a capital gain or loss on the sale of a security.
How are Non-Qualified Stock Options taxed?
Non-qualified stock options are taxed differently than qualified stock options. With a non-qualified stock option, you are taxed at the time you exercise the option. The amount of tax you pay is based on the difference between the strike price and the fair market value of the stock at the time you exercise. You will also pay capital gains taxes if you sell the stock for more than the strike price.
Advantages and Disadvantages of Non-Qualified Stock Options
There are a few key differences between non-qualified stock options (NQSOs) and qualified stock options (QSOs). Namely, NQSOs are not subject to the same favorable tax treatment—they are taxed as ordinary income at the time of exercise.
Another key difference is that NQSOs can be granted to anyone, including employees, contractors, and even non-employees. By contrast, QSOs can only be granted to employees.
NQSOs also have less stringent requirements in terms of vesting and holding periods. Vesting simply means that the employee must wait a certain amount of time before they can exercise their stock options. With NQSOs, this vesting period is often shorter than with QSOs. And there is no requirement to hold onto the stock for a certain period of time after exercising the option—the employee can sell the shares immediately if they wish.
All of this means that NQSOs offer more flexibility to both employers and employees. But there are some drawbacks to consider as well.
Because they are taxed as ordinary income, NQSOs can result in a higher tax bill for employees than QSOs. And because there are no special rules or requirements governing them, there is more potential for abuse with NQOSOs. For example, an employer could grant a large number of NQOSOs just before a big run-up in the stock price
When to Exercise NonQualified Stock Options
Non-qualified stock options (NQSOs) are options that do not qualify for special favorable tax treatment under the Internal Revenue Code. Generally, this means that when you exercise an NQSO, you will pay ordinary income tax on the difference between the strike price and the fair market value of the stock at the time you exercise, regardless of how long you hold the shares.
There are no rules around when you can exercise NQSOs, so it’s important to talk with your financial advisor or tax professional to determine when exercising them will be most advantageous for you. In general, however, it makes sense to exercise NQSOs when the stock price is high relative to the strike price because that’s when you’ll have the greatest potential gain. Keep in mind, though, that you’ll also have a greater tax liability when you exercise NQSOs at a high stock price.
What are the Major Differences Between ISOs and Nonqualified Stock Options?
ISOs and NSOs have a lot of similarities. Both types of stock options provide employees with the opportunity to purchase shares of the company at a set price, known as the strike price or exercise price.
The main difference between NQSOs and ISOs is that NQSOs are not eligible for preferential tax treatment, while ISOs are. With NQSOs, employees pay ordinary income tax on the difference between the strike price and the fair market value of the stock at the time they exercise their options. With ISOs, employees may be eligible for capital gains treatment if they hold onto the shares for at least one year after exercising their options.
Another key difference between NQSOs and ISOs is that there is no limit on the number of NQSOs that a company can grant to its employees, while there is a limit on the number of ISOs that can be granted in a given year. The ISO limit is 100 per employee, with a maximum aggregate grant amount of $2 million. Employers typically use NQSOs as a way to attract and retain top talent, since they offer employees greater flexibility in when they exercise their options and how they are taxed. ISOs are often used as a way to reward long-term performance since they require employees to hold onto their shares for at least one year
Vital Things to Know About How Your Stock Options are Taxed Before Doing Anything
#1 Qualifying Sale Event of an ISO
Your sale is qualifying if (your gain is taxed at long term capital gains rates):
- You held the stock for longer than two years from the GRANT date, and
- You held the stock for longer than one year from the EXERCISE date, and
- You exercised the shares within three months after you severed ties with the employer granting the ISO.
Why Should We Aim To Have a Qualifying Sale?
- Capital Gains Tax: The taxable capital gains would be the difference between the selling price and the exercise price. You may also deduct any brokerage fees or commissions from the selling price. The capital gains from the sale will be subject to capital gains tax which could be either 0%, 15%, or 20% depending on your income bracket.
- Ordinary Income Tax: None. Instead, you will receive a 1099-B.
Disqualifying Sale Event of an ISO (Not to Be Confused With a Non-Qualifying Stock Option)
If the transaction doesn’t meet all the conditions above, it is a disqualifying distribution. Why does that matter? Because the “bargain element” aka the discount you received by using your ISO on the stock when you bought it you’ll have to pay ordinary income taxes on. You can calculate the bargain element by figuring out the difference between the fair market value when you sell the stock and your purchase price.
Taxes On A Disqualifying Sale Event Made On The Exercise Date
- Ordinary Income Taxes: You will pay ordinary income tax on the bargain element.
- Short-Term Capital Gains Tax: Since this would be a disqualifying disposition because the shares were sold less than one year from the exercise date, the difference between the sale price and the exercise price (the price you get to buy at because of your ISOs) will be taxed at short-term capital gains rates which are the same as ordinary income tax rates. Ouch.
Taxes On A Disqualifying Sale Event Less Than 1 Year From The Exercise Date
- Ordinary Income Tax: You will pay ordinary income tax on the bargain element.
- Short-Term Capital Gains Tax: Since this would be a disqualifying disposition because the shares were sold less than one year from the exercise date, the difference between the sale price and the exercise price (the price you get to buy at because of your ISOs) will be taxed at short-term capital gains rates which are the same as ordinary income tax rates. Ouch.
Taxes On A Disqualifying Sale Event More Than 1 Year From the Exercise Date But Less Than 2 Years From the Grant Date
- Ordinary Income Tax: You will have to pay ordinary income tax on the bargain element.
- Long-Term Capital Gains Tax: Since the shares were sold more than a year from the date you bought the stock (the exercise date), the difference between the price sold the stock for and the price you paid for the ISO shares will be subject to the lower long-term capital gains tax which could be either 0%, 15% or 20% depending on your tax circumstances.
What if I sold the shares at a price lower than the market value at the exercise date?
If the sales price is lower than the market value at the exercise date, you may use the difference between the lower sales price and the exercise price unless:
- It was a wash sale where you repurchased shares in the same company 30 days before or after you sold the shares.
- You sold the shares to a related party such as a family member or a partnership or corporation where you own more than 50% interest
- You donated the stock to a charity or an individual
Do I have to pay taxes when I exercise ISOs?
- No, you only pay taxes when you sell the stock. You may have to pay the Alternative Minimum Tax when you exercise your ISOs, however.
#2 The Best Time To Exercise ISOs
When is the best time to exercise your ISOs?
Deciding the exercise of an iso and sell your ISOs depends on your goals.
How To Minimize Your Risk Of Holding Your Stock Options
Working for a company and holding that company’s stock may be a huge mistake. What if you lost your job because the company started doing poorly at the same exact time that your shares were suffering?
Many people exercise their ISOs immediately upon receiving them for that reason and sell the stock immediately after they reach the point they can make a qualifying disposition. Some people even exercise and sell the stock in the same year just to protect themselves financially. If you don’t have the dough to exercise your ISOs, I don’t blame you. It could be incredibly expensive. Read below on how to do a cashless exercise.
How To Minimizing Ordinary Income Tax Upon Sale
If you are a high-income earner you may want to avoid being taxed at ordinary tax rates because the top federal tax rate in the country is 37% right now and minimize the tax consequences of benefiting from your ISOs. Add on city, state, and local and you could be at 49%.
If minimizing ordinary income tax is important to you at this point, you should focus on meeting the requirements for a “qualifying disposition” by holding your ISOs and the stock you receive subsequently at least at the minimum holding period. A qualifying disposition is when you wait for a minimum of two years from the option grant date of your ISOs and at least a year from the exercise date before you sell your ISO shares. In qualifying disposition, the difference between your purchase and sale price will be taxed as long-term capital gains, which is between 0% and 20%.
Minimizing Unknown Future Capital Gains Taxes
The Tax Cuts and Jobs Act retained the preferential treatment for long-term capital gains tax but this may not always be the case. Congress will likely reconsider most of the provisions in the TCJA in 2025.
Maximizing The Value of The Stock
If you want to profit from the appreciation of your company’s shares, hold the ISO as long as your company is performing well. Since your goal is to sell the stock for more than you paid for it, you may want to exercise your ISOs and purchase your company’s shares on the year you plan to sell those shares. If you do this, the transaction would absolutely be a disqualifying disposition that’ll be subject to ordinary income because you sold the same year you exercised. It’ll also be subject to AMT in the year you exercised your ISO, so go in with your eyes open on what to expect or else.
Changes In The New Tax Law Might Change Your ISO Strategy
New tax changes increased the exemption limit for AMT. This means that you’ll be able to exercise more ISOs before triggering AMT which could be really valuable to you. In addition, this could cause more companies in tech to issue more ISOs. What does this mean to you? If you have a lot of ISOs come 2025 and the AMT credit is decreased, you could find yourself in a tough situation.
#3 A Few Additional Considerations when you’re exercising your ISOs
Special Considerations
When the vesting period expires, the employee can purchase the shares at the strike price, or “exercise the option.” Then, the employee can sell the stock for its fair market value, keeping the difference between the strike price and the sale price as profit.
Of course, there’s no guarantee that the stock price will appreciate at the time the options vest. If it’s lower, the employee may hold onto the options until just before the expiration date. ISOs usually in 10 years. There’s nothing wrong with not exercising because you don’t lose if you don’t buy the stock, to begin with.